(MONEY Magazine) – So you've read every word of the previous stories, taken copious notes and are psyched to call your benefits department to create, or reallocate, your 401(k) plan based on what you've learned. But you've got one nagging question: When can I get my hands on the cash? The answer: probably anytime you need to, as long as you understand the rules. Although you can withdraw money from your 401(k) while you're working only if you're suffering a financial hardship, you can always borrow against your plan account if your company allows loans. In fact, at any given time 20% of 401(k) loan participants are borrowing against their plans. Once you're retired and older than 59 1/2, you can take money out of your 401(k) plan without owing any tax penalties. But here's a better question to ask: Is it a good idea to take money out of my 401(k)? Answer: only if you're very careful and really need to do so. After all, extracting money from your 401(k) means thumbing your nose at an immediate tax shelter, siphoning off your retirement savings, possibly forgoing investment earnings plus perhaps boosting your current tax bill. Still, sometimes pulling money out of a 401(k) can be a handy way to help reach other financial goals. Providence, R.I. legal assistant Chris Lionette, 30, and his wife Kathy, 27, pictured at left, like knowing that Chris' small but growing 401(k) account is available to them--if they absolutely need it--for a down payment on a home within a few years. If his law firm didn't allow loans, he says, he might not put as much money into a 401(k) right now. "I like knowing that we have it as a safety net," Chris says. Still, raiding their retirement money is not a decision the Lionettes take lightly. "It's not play money for us," says Chris. "We take saving very seriously, and we will put in as much as we can after we buy a house." Whether you're thinking about taking a short-term loan like the Lionettes or pulling out some of your savings in retirement, read on to learn how best to tap your 401(k) money--and when alternative sources of cash are smarter.


Promise yourself that you won't succumb to temptation and pull money out of your 401(k) just to have more spare cash on hand. But if you have a legitimate reason to take money out of your account--such as needing money to buy a home or send a child to college--you'll want to know your options in advance. Essentially, there are two: loans and hardship withdrawals. Roughly 80% of companies with 401(k) plans now let employees borrow as much as half the money in their 401(k), to a maximum of $50,000. If your company permits it, as roughly 40% of those with 401(k)s do, you can even have more than one loan going at the same time, as long as your outstanding debt doesn't exceed the limits. Some employers, such as Chris Lionette's law firm, allow loans only for serious purposes, such as buying or remodeling a home. But nine out of 10 plans that allow loans let you borrow for any reason at all. Borrowing from your 401(k) is much smarter than simply withdrawing cash. That's because with a loan you eventually replace the money in your own tax-sheltered account; you have five years to repay the loan or, if you're using the money to buy a home, as long as 30 years. Loans also let you avoid owing the immediate taxes due on withdrawals and the 10% penalty for nonretired people younger than 59 1/2. A 401(k) loan is generally one of the least expensive ways to borrow today too. The 401(k) interest rate is generally one or two points above the prime lending rate (making today's rate 9.25% to 10.25%). By contrast, banks typically charge six or more points over prime for personal loans. There are two major drawbacks to a 401(k) loan. First, borrowed 401(k) money earns only the interest you pay yourself, not the higher returns the cash might earn if you had kept it invested in the plan. Over the past five years, for example, the average U.S. equity fund has returned an attractive 14.1% a year, well above the average prime rate. The other problem with 401(k) loans is that to keep one, usually you must keep your job. Fewer than a third of employers with 401(k) loan provisions let former workers continue making installment payments. "If you quit or get laid off, you may have to pay off the entire loan within three months," warns Michael Sternklar, a consultant with Kwasha Lipton, an employee-benefits firm in Fort Lee, N.J. If you default, the IRS will treat the unpaid balance as a withdrawal, subject to income taxes and a 10% penalty if you're under 59 1/2 and haven't retired. A large unpaid 401(k) loan balance could even push you into a higher tax bracket. Given the downside to 401(k) loans, homeowners needing cash for important expenses like college or medical emergencies ought to consider a home-equity loan instead. With a home-equity loan, your interest rate won't be much higher than a 401(k) rate; it could even be lower. (Today's national average: 9.65%.) And unlike a 401(k) loan, interest on a home-equity loan is usually tax deductible. As a result, your money is almost certain to earn more if left in the 401(k) plan than it will cost you, after tax, to borrow against your home (see the table below).

If you're in the 28% federal tax bracket (taxable income of roughly $94,250 for married couples and $56,550 for singles) and you pay 5% in state and local taxes, a 9.65% home-equity loan costs you just 6.47% after your deduction. Follow the advice in the preceding stories, and you should be earning more than that on your 401(k) investments.

If you decide that a 401(k) loan is the right move, remember that by taking out a fixed-rate loan on which you pay interest to yourself, you're effectively adding a fixed-income investment to your 401(k) account. You may therefore need to remix your 401(k) portfolio to make up for the low return on the loan. Ask your benefits department how the company will debit the loan. Some employers deduct it from your least speculative investments; more commonly, it is drawn proportionately from all the funds in your account. Then, if necessary, adjust your portfolio to keep the investment mix on track with your goals and risk tolerance. Here's an example: You have a $20,000 account balance--half in a stock fund, 25% in a bond fund and 25% in a guaranteed investment contract (GIC)--and you borrow $5,000 drawn proportionally from the funds. To keep the same investment mix, you should put two-thirds of the remaining GIC balance, or $2,500, in the equity fund and the other third, or $1,250, in the bond fund. That way you again have $10,000 in the equity fund, $5,000 in the bond fund and $5,000 in a fixed-income investment. Okay, let's say that you have maxed out on borrowing or that your employer doesn't offer loans, and a financial emergency strikes. You need cash. Now what? Fortunately, 92% of employers with 401(k)s permit early withdrawals for financial hardship. Most stick to the four hardship exemptions cited in the tax code: paying college tuition for yourself or a dependent; purchasing your primary residence; covering any out-of-pocket medical costs; and preventing foreclosure or eviction from your primary residence. Some 18% of plans permit other hardship withdrawals, such as for funeral expenses or child support. Though the ability to withdraw money from your 401(k) provides a comforting safety net, it's an extremely pricey option that should be used only as a last resort. Keep in mind that this is an irreversible move: You can't replace the money later on. What's more, you'll owe income taxes on the amount you take out of the 401(k) and probably the 10% early-withdrawal penalty. Worst of all, by law your employer must withhold 20% up front for taxes; so to receive the money you really need, you have to take out 25% more than you want. When you file your tax return, you'll get credit for the 20% you paid, but you'll have to ante up any additional taxes due. To get your hands on an immediate $10,000, for example, you'd need to withdraw $12,500. Next April, if you're in, say, the 28% federal tax bracket and pay 5% in state and local taxes, you'd owe an additional $1,000 in taxes plus a 10% penalty of $1,250--plus $625 in state and local taxes. So the amount you'd ultimately keep from a $12,500 withdrawal would be just $7,125--or 57% of what you took out of your plan. (The withdrawal penalties are waived if you are 55 or over and have retired early.) Rather than forcing your employer to act as a private investigator and prove that you have no other source for the money, the IRS okays hardship withdrawals as long as your company prohibits you from contributing to your 401(k) for a year after making a withdrawal. As a result, during that time, you forgo not just your tax-sheltered salary deduction but also any employer match as well. Given all these drawbacks, if a cash crunch hits, you'd probably be better off dipping into your emergency funds or getting a loan from your family and friends. When you change jobs, be sure not to make one of the most common 401(k) mistakes: taking your entire plan account in cash, rather than reinvesting it in another tax-deferred retirement plan. According to Olena Berg, the Labor Department's assistant secretary for pension and welfare benefits, a whopping 79% of workers who quit or get fired and take the cash from their 401(k) plans elect not to reinvest all of it in another retirement plan. By failing to do so, you not only subject your savings to immediate taxes and the 10% penalty for withdrawals, you also jeopardize your future financial security because compounding tax-deferred money is the best way to save for your retirement. If at all possible, when you leave a job and a 401(k), choose instead one of the following three options: Leave your money where it is, transfer it to your new employer's 401(k) or roll it into an Individual Retirement Account. As long as your account exceeds $3,500, you can leave your money in your former employer's plan until you retire. You won't be able to contribute more to it, but the account will keep making money for you, and you can always roll over the money into a different sheltered account later. So if you need time to think over your options, this might be the best short-term move. Long term, however, there are disadvantages to leaving the money in your former employer's 401(k). For starters, you won't be allowed to borrow against the account. And since you can no longer contribute to it, the company won't match any funds. So unless the investments in your account are doing spectacularly well, don't leave your money in your old plan any longer than necessary. If your new employer offers a 401(k), you usually can transfer your cash to that plan, although you may have to wait a year or so to become eligible to make new contributions. (In April, President Clinton proposed eliminating that waiting period and making it easier for employers to accept rollovers.) Switching from one employer's plan to another is your best strategy, since a 401(k)--and its cousins at nonprofits--is the only savings program that offers matching contributions. Make sure if you roll money into a new 401(k), however, that your old employer hands over the money directly to the new plan's trustee--not to you. If you are the recipient, your employer has to withhold 20% for taxes. What's more, you'll have to replace the missing 20% from your own pocket within the 60 days allowed for a rollover. Otherwise, that amount will be considered a withdrawal, subject to taxes and the 10% penalty. If your new company has no 401(k) plan or doesn't allow rollovers, or if you simply want more investment choices than the four to six offered by most employers, an IRA is your best bet. Tip: Set up a new IRA account, sometimes called a conduit IRA, and then keep your mitts off it. If you don't mix that money with other contributions, you'll be allowed to roll it back into a 401(k) plan in the future. As with the transfer described above, make sure the money goes directly to your IRA trustee. And remember, says employee-benefits expert Bob Walter of Buck Consultants in Harmon Meadow, N.J.: "Keeping as much of your money in a tax-deferred account as you can is the best way to save for retirement."


Congratulations. you've made it to age 59 1/2 the age at which you can kiss those 401(k) early-withdrawal tax penalty rules good-bye. You've worked hard, invested wisely, kept borrowing to a minimum and are ready to start enjoying the fruits of your labor in retirement. Not so fast. Sorry to break the news, but when it comes time to start pulling money out of your 401(k), you'll face a tangle of irrevocable tax and investment decisions that could tarnish your golden years if you mishandle them. Make the right moves, however, and your 401(k) will be your ticket to a cushy retirement. Step No. 1: Get help from a professional tax adviser. Says Paul Westbrook, a retirement planner in Ridgewood, N.J.: "Deciding how to handle your 401(k) at retirement is not a do-it-yourself job."

To help guide you, we've laid out the seven most common questions about 401(k) withdrawals in retirement and the wisest answers, according to financial planners and benefits consultants.

--When do I have to start taking money out of my 401(k)? Though the tax law says you can begin making penalty-free withdrawals at 59 1/2 or 55 if you took early retirement--you don't have to begin shoveling out any of the cash until you are 70 1/2. So if you can swing it, try to draw on funds outside your 401(k) and other tax-favored accounts, letting you continue to shelter your earnings from the IRS for as long as possible.

--What if my 401(k) is performing well, and my former employer will let me leave the money where it is? Do just that. For one thing, this will give you even more time to map out your post-career investment strategy. "A lot of investment sharks are after this money," warns Harry Purnell, a principal and actuary at the employee-benefits firm Foster Higgins in Princeton, N.J.

Equally important, leaving the money in the 401(k) may offer you tax advantages that the alternative, a rollover IRA, can't match. For starters, since the tax law limits annual pretax contributions to 401(k) plans to $9,500, some companies allow employees to contribute after-tax dollars as well. The hitch: The tax law won't let you put after-tax money in a rollover IRA when you retire. So if your 401(k) fund has sizable after-tax contributions, leaving the money alone is the only way to get tax deferral on your entire account. Also, once you transfer money to an IRA, you forgo the right to elect special tax treatment, explained at left, available if you pocket a lump-sum payout. Check out your plan's rules regarding retirees' accounts, though, in its latest summary plan description. If the information isn't there, ask your plan administrator for a set of written rules. Some can be restrictive. Once you leave the company, for example, your 401(k) might not let you switch among the various investment options as often as you could when you were an employee. In addition, most plans won't let you take sporadic withdrawals. Rather, as the old Frank Sinatra song says, they require you to take out all or nothing at all.

--But what if my former employer won't let me keep my 401(k) account with the company in retirement or I'd just rather have total freedom investing the cash? Move the money to a rollover IRA, says Ellen Breslow, director of individual retirement plan services at the Smith Barney brokerage firm in New York City. You can roll the money into an existing IRA or open a new one. To do this properly, instruct your 401(k) plan administrator either to transfer the money directly by wire into your IRA or to give you a check made out to your IRA trustee. Make sure the distribution check is not made payable to you. If it is, you have 60 days to transfer the money into an IRA account yourself. If you don't act within 60 days, the entire amount is deemed taxable. To make matters worse, if the check is made out to you, your employer must withhold 20% for income taxes. So if you have a $100,000 account, you would get a check for only $80,000. To roll over the entire $100,000 within the 60-day window, you'd have to come up with the missing $20,000 on your own and add it to the $80,000 check you deposit in your IRA. Can't come up with the 20 grand? Then the tax law says you've made a taxable withdrawal of that amount. Result: You'll owe income tax on the $20,000--a $6,600 tax hit, assuming a combined 33% federal, state and local tax bracket.

--I want to get my hands on all the cash in my 401(k) right away to buy the RV of my retirement dreams. What should I do? If you want to pocket your stash rather than roll it over, you need to plan ahead to minimize your tax hit. Generally, the best strategy for reducing Uncle Sam's bill is to use a special calculation called forward averaging. With five-year forward averaging, available to anyone 59 1/2 or older who has participated in his or her 401(k) for at least five years before the year of the distribution, you compute the taxes due as if you received the money over five years instead of all at once. The savings can be hefty: As the table on page 127 shows, without averaging, a couple getting a $300,000 lump-sum 401(k) payout might owe $118,640 in taxes, assuming they had $40,000 of other income; with five-year averaging, the tax would be $83,678, or 29% less. However, the benefits of five-year averaging wane as your payout gets larger, and once your distribution tops $1,318,750, five-year averaging gives you the same tax bill as the ordinary income tax calculation. If you were born before 1936--people now 60 or older--you can instead choose 10-year forward averaging, which often saves you even more in taxes. With 10-year averaging, you compute your tax as if you had received your payout over 10 years, using the tax rates for singles that were in effect in 1986. For distributions of up to $358,250 this is the way to go, if you qualify. Using this example, the tax you'd owe on $300,000 with 10-year averaging would be just $81,330, vs. $83,678 using the five-year method. To complicate life even further, if you take lump-sum distributions from more than one retirement plan during the year--say, from your 401(k) and your pension plan--and you want to use forward averaging, you must apply it to all your lumps. So if you'd like to roll over one of the payouts into an IRA and forward average the other, arrange to take your distributions in different years. One final caution: If you plan to use forward averaging on a lump sum exceeding $775,000 in 1996, you'll be hit with a 15% excise tax penalty on the amount over $775,000. That's because of the "excess distribution" rules that are designed to ensure that taxpayers use 401(k)s and other tax-sheltered savings plans to build up an adequate retirement fund--not to amass family fortunes. (The threshold is adjusted periodically for inflation.) If you're planning on taking $775,000 in a lump sum, see your tax adviser before you do. He or she may be able to suggest ways to avoid or mitigate the combination of taxes and penalties that you will owe.

--How about if I'll need some, but not all, of the cash in my 401(k) soon? Then you'll most likely want to dump your 401(k) into a tax-deferred rollover IRA and simply make taxable withdrawals as needed. But unless you have to, don't take out more than $155,000 in any single year. Reason: If the sum of your annual withdrawals from all your tax-sheltered nest eggs exceeds $155,000, you'll get hit with a 15% penalty on the excess in addition to the income tax. (The $155,000 annual limit also adjusts for inflation but increases only in $5,000 increments.)

--Is there any way to get my ex-employer to give me regular periodic payments from my 401(k)? That depends on whether the company is one of the roughly one-third of 401(k) plan sponsors that offer an installment payment option. If it is, you select a payout period--typically five to 15 years. Choose 10 years, for example, and you'll get one-tenth of your balance in Year One, one-ninth in Year Two and so on until your account is depleted at the end of 10 years. You'll owe income tax on the payouts in the year you receive them.

--What do I have to do once I hit age 70 1/2? At this age you must begin taking specified annual amounts out of all your tax-sheltered accounts, such as your IRA, 401(k) or 403(b). How you make these withdrawals will have income tax consequences and possibly estate-tax repercussions as well. To brush up on the rules and issues surrounding mandatory distributions, get a copy of IRS Publication 590--Individual Retirement Arrangements. It's available free by calling 800-829-3676 or on the World Wide Web ( The minimum amount you must withdraw once you turn 70 1/2 is based on two factors: your life expectancy as determined by IRS tables (if you have a beneficiary, you'll use one figure representing your joint life expectancy) and the total you have in each tax-sheltered account. For example, if you and your spouse are both 71, your joint life expectancy is 19.8 years. If you have a $100,000 rollover IRA, you must withdraw at least $5,051 ($100,000 divided by 19.8). You can take out more, but failure to take at least the required minimum means owing a tax penalty equal to an eye-popping 50% of the shortfall. To lower your minimum annual payout, name as young a beneficiary as you can. Most people choose their spouse. But if he or she is adequately provided for through other means, naming someone younger will help both of you stretch your 401(k) money in retirement. A younger sibling, for example, raises your joint life expectancy, which, in turn, lowers your payout. For instance, the 71-year-old IRA owner in the above example would lower his mandatory payout from $5,051 to $3,953 if his beneficiary was 61 instead of 71. Suddenly feeling very generous toward your 12-year-old grandchild? Forget it. If your beneficiary is not your spouse, the IRS tables impose a maximum 10-year age spread between you and your beneficiary to prevent you from drastically reducing your payouts. After choosing a beneficiary, you'll need to select a method for calculating your life expectancy. The IRS permits two methods: recalculation and term certain. The choice you make is irrevocable, so consider your options carefully. Under the recalculation method, the IRS uses an actuarial table to newly figure the life expectancy of you and your beneficiary every year. Based on the reassuring conviction that the longer you live, the longer you're expected to go on living, the recalculation method reduces your life expectancy by less than one year for each year you live. This method is appropriate if you want to stretch out your minimum payments over as many years as possible and maximize your tax-deferred buildup. The term-certain option establishes your life expectancy up front and drops it by one year every year. Thus if your life expectancy is 20 years when you take your first mandatory withdrawal, it will be 19 years when you make your second, and so on until your account is depleted at the end of the term. With term certain, your 401(k) is depleted sooner than if you used recalculation. You may prefer this if you want to assure yourself a stream of payouts for a definite time period but are also interested in pulling money out of your account so that you can give it as a gift to your heirs--thereby reducing the size of your estate and possible future estate taxes. Clearly, knowing the ins and outs of 401(k) withdrawals is key to reaping a bountiful retirement harvest. "For decades, the money in your 401(k) was your savings for the future," says retirement planner Westbrook. "Now it's the source of your income for today. You have to plan to make sure it lasts as long as you do."